You say that “The intellectual case for an accelerated pace of economic reform has been well established in China. If Xi and Li can overcome the entrenched vested interests that have slowed reform to a crawl in recent years they will be laying the foundation for stronger economic growth over the medium term.”

I agree with your first sentence. Few economists still doubt that China’s growth model is unsustainable and will require a dramatic transformation of the financial sector and the relationship between the state and the economy. Your second sentence, however, leaves me with two questions. First, what does it mean for Li and Xi to overcome vested interests? Second, even if they do, how can subsequent growth rates remain high?

To address the first question, after many years, as I see it, several groups within China have benefitted mightily from the distortions associated with the current growth model, especially distortions in interest rates, the currency, and China’s heavy dependence on investment. Given how deep these distortions have been, and how long they have been in place, it would be surprising if these groups had not become extremely powerful.

These distortions need to be reversed. The historical precedents for developing countries that have attempted to reverse similar distortions, however, suggest that the biggest impediment to the adjustment process will be opposition from these groups. Jeffrey Frieden in his 1993 book on Latin America, for example, argues that the Latin America adjustment in the late 1970s was extremely slow and painful precisely because powerful vested interests were so successful in retarding or diluting reform.

Looking at China today, it is hard for me to believe that the groups that benefitted from the old development model are less powerful than they were in Latin America in the 1970s. This is not to say that overcoming elite resistance is impossible, but it does suggest that it is going to be much harder than many expect, and will almost certainly require a lot more time and a much greater sense of urgency on the part of policymakers. It took the crisis of the 1980s, remember, before Latin America managed to force through many of the necessary changes.

As for the second question, it is still unclear what Beijing can do to replace the source of growth. Of course as they reduce the investment growth rate, consumption will become relatively more important as an engine of growth. But even if consumption continues growing at 7% to 8% percent annually, as it has in the past decade, it will still not be enough to drive GDP growth rates much above 3% to 4% until at least a decade from now, when household consumption represents 50% to 60% of GDP. China needs, in other words, not just to maintain the last decade’s consumption growth rate. It needs substantially to increase it.

Again, this is not impossible, but it requires some specific mechanism that causes household income to grow much faster than it ever has since the 1980s – and all this during the worst domestic and global environment it has ever experienced. A massive transfer of wealth from the state sector and from China’s economic elite to the household sector would of course do the trick, but it may well be the only way, and I am perhaps more pessimistic than you are that it will prove politically easy to achieve. My reading of history suggests that the very powerful state sector and the equally powerful economic elites will strongly resist any such transfer.

I have no doubt that Beijing will eventually achieve its objectives, but I doubt it can do so as efficiently and effortlessly as it must if it is to avoid much slower growth rates for many, many years. This process has not been easy for any country in history, and it is hard for me to imagine why it will be easier for China when many of the conditions that made it difficult elsewhere may be even more extreme in China.

Remember that we are not just asking China to make an adjustment that very few countries in history have been able to make successfully. We are asking China to adjust from greater imbalances and under worse external conditions, and to do so much more successfully than has ever been done before. This of course is not impossible, but it is not clear to me why we would not find it improbable.

Best regards,

Michael

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Dear Michael,

We both believe that investment as a share of GDP in China is too high and must come down and that the external sector is not likely to be a major contributor to growth over the next few years. Our disagreement appears to arise over three issues. First, how rapidly must the downward adjustment in the investment share occur? Second, could more robust consumption expenditure offset part of the adverse growth effect of slowing investment? Third, what is the role of government policy in shaping the rebalancing?

You appear to hold the view that the growth of investment must slow sharply to bring down its share fairly quickly. Given your assumption that consumption growth will trend along at 7%, to bring GDP growth down to your hypothesized rate of only 3% to 4% would require investment growth to grind almost to a halt. Yet this is hardly necessary or optimal. China has pursued an imbalanced growth strategy for almost a decade; there is no reason that the resulting imbalances have to be reversed overnight. While investment in heavy industry and housing must moderate, investment in consumer goods industries and large swaths of the service sector may actually pick up as rebalancing proceeds.

Second, assuming there is a 7% cap on real consumption growth is problematic to say the least. To begin with real private consumption expanded by an average of almost 10% per year over the last decade, not “roughly 7%,” and last year it rose by more than 11% in real terms. Importantly, while the growth of real investment has fallen below its decade average in the past two years the pace of real consumption growth has been above its decade average. This suggests the potential for more robust consumption expenditure to offset slowing investment growth is far from theoretical.

Third, your analysis suggests that the outcome of rebalancing is foreordained to be a collapse of economic growth. But the future is not entirely determined by arithmetic. This ignores both the underlying dynamics of the Chinese economy and the scope that government policy has to encourage more rapid growth of private consumption expenditure.

As the growth of the labor force slows in coming years, wages are likely to grow even more rapidly than in the recent past, possibly reversing the long term slide in the wage share of GDP, which has accounted for a large share of the decline in household consumption as a share of GDP. The flip side is likely to be a reduction in what is called the operating surplus of enterprises, which will lead to a slowing of investment. Moreover, a large and growing share of investment is now being undertaken by firms where private shareholders are the majority or dominant owners. Over time this will lead to increasing efficiency of investment so that GDP growth need not slow in lock step with investment.

On the policy front the government should further reduce and eventually eliminate its intervention in the foreign exchange market and eliminate subsidies to industrial energy consumption. The undervalued exchange rate and subsidized energy of the past decade have tilted investment into manufacturing and out of services. Since services, on average, are more labor-intensive these reforms would redirect investment in a way that would be positive for employment growth and thus would reinforce the growth of the wage share that is likely to accompany slower labor force growth.

The government should also continue to build out the social safety net, which will mean that every family will not have to self-insure against the risk, for example, of a major medical event. That could contribute to a gradual reduction in the household savings rate.

Similarly ending the extreme financial repression of recent years — reflected in a real one-year deposit rate that has on average been in negative territory beginning in 2004 — could also contribute to a decline in the household savings rate. The impact of these reforms is potentially quite large since the rising household savings rate has been the biggest single drag on consumption growth in the past couple of decades. Long term private consumption growth from the early 1990s to the end of the last decade averaged 9% per annum in real terms. But if the household savings rate had not gone up, private consumption expenditure would have grown by almost 10% annually.

In short, rebalancing is a medium term project that will not be easy. To be successful the government will need to phase out policies that favor profits at the expense of wages, borrowers at the expense of savers, and manufacturing at the expense of services. If this can be done China will not resume double digit growth but it will probably escape your postulated 3% to 4% pace of expansion.

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